Pages

Monday, 8 September 2014

Islamic banks face challenge from Basel III deposit regulations

As banks around the world gear up to meet tough Basel III regulatory standards, Islamic lenders face a source of uncertainty that could prove expensive for them: how regulators will treat their deposits.

In most ways, Islamic banks look well-placed to cope with Basel III, which will be phased in across the globe over the next few years. Most of the banks are from the Persian Gulf and Southeast Asia, where economies are strong.

Since Islamic finance frowns on monetary speculation, their balance sheets are largely clear of the derivatives and complex, risky assets that sunk some of their conventional peers during the global financial crisis. They should therefore have little trouble in meeting Basel III's minimum capital standards.

But their deposit bases could become a headache. Because interest payments are not allowed by sharia principles, Islamic banks obtain deposits mostly through profit-sharing investment accounts (PSIAs), which are considered to be more volatile than conventional deposits.

Islamic banks are expected to be required to offset that volatility under Basel III by increasing the amount of high-quality liquid assets (HQLAs) they hold. But Islamic securities markets are younger, shallower and less developed so sharia-compliant HQLAs are in short supply - squeezing banks on two fronts.

"These are two of the more important challenges that Basel III is introducing to the Islamic finance industry," said Paris-based Mohamed Damak, primary credit analyst at credit rating agency Standard & Poor's.

Islamic commercial banks held about US$1.2 trillion worth of assets at the end of last year, according to Thomson Reuters. They account for roughly a quarter of deposits in Gulf Arab countries and over a fifth in Malaysia.

Basel III requires banks to hold enough HQLAs to cover net cash outflows for a 30-day period under a high-stress scenario. Outflows are calculated by applying different weights to funding sources, including PSIAs. The riskier the funding source, the larger the amount of HQLAs needed to cover it.

So a lot will depend on the weights or "run-off rates" which national regulators around the world, who will implement Basel III in their own jurisdictions, choose to assign to PSIAs.

Regulators have yet to give an indication of the likely weights. They are keen to develop their Islamic banking sectors, so they are unlikely to assign punitive weights. But they may not be able to treat PSIAs as benignly as conventional bank deposits.

The treatment of PSIAs will also depend on factors specific to the Islamic banking industry in each country, such as how it behaved in past stress situations, and the track record of Islamic banks in passing losses on to deposit holders under their contracts, Damak said. The uncertainty looks unlikely to be cleared up at least until early next year, when the Malaysia-based Islamic Financial Services Board (IFSB), a global standard-setting body, is expected to release a guidance note on the subject.

"Ultimately it is the regulator in each country that will decide what will be the treatment of PSIAs, and here the IFSB guidance note will be of significant value to help regulators decide how to treat PSIAs," Damak said.